Focus shifts back to the Fed

July 25, 2016

Markets during the past week have been characterized mostly by a continued rally to new record highs for equity markets, most notably in the US where earnings season has entered full swing. Stock indexes have been buoyed by largely better-than-expected earnings reports, albeit on relatively low expectations.

Also helping stocks to continue their climb recently have been the prevailing accommodative stances among major central banks, including those in the UK, Japan, and the Eurozone. Both the Bank of England (BoE) and the European Central Bank (ECB) opted to keep interest rates unchanged and refrain from introducing new stimulus measures in their policy statements within the past two weeks. At the same time, however, both central banks continued to express concerns over the fallout from June’s Brexit vote, and both are expected to implement more easing in coming months. Disappointing UK PMI data released on Friday could also help to accelerate the case for impending BoE easing.

As for Japan, a resurgence of support for Japanese Prime Minister Shinzo Abe’s economic stimulus objectives has been tempered somewhat by reports that the Bank of Japan may also opt for inaction during its meeting next week. Despite this, the trajectory of Japan’s monetary policy appears rather clear in light of Abe’s assurances of further stimulus.

While helping to boost equity markets, the general lean towards further monetary easing by these central banks has placed increasing pressure on their respective currencies in the past few weeks. The pound, euro, and yen have all been weighed down against their chief rival, the US dollar.

With respect to the dollar, focus will shift next week from Europe back to the US Federal Reserve and its tenuous monetary policy stance. With other major central banks on a path towards more easing, the Fed now stands alone in its policy-tightening objectives. These objectives have likely been reinforced recently as concerns over Brexit consequences have faded in the US and economic data releases have consistently shown a relatively optimistic picture of the US economy. The question remains, therefore, as to whether the Fed will be swayed by its global counterparts during next week’s FOMC meeting, or will it focus more on the positive markers of the US domestic economy.

The likelihood of an actual rate hike by the Fed next week is very low, as significantly more data will likely be needed to convince the ever-cautious Fed that raising interest rates would be appropriate. As always, markets will take their cues from the language of the policy statement, especially with respect to the potential timing of the next rate hike and how many hikes might be expected by FOMC members in the coming months.

More hawkish-leaning language that acknowledges improving economic indicators and suggests a possible September rate hike should likely lead to a continued surge for the US dollar, a further drop for gold, and a pullback in soaring equity markets. In contrast, if a dovish stance prevails that falls more in line with global trends, which could suggest a lower likelihood of a rate hike this year, gold could see a rebound, equities could climb to even higher record highs, and the dollar’s recent rally could quickly experience a sharp reversal.

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